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Tuesday, May 18, 2010

Noble Profits

While Barnes and Noble (BKS) has averaged operating income of over $200 million per year over the last four years, the company trades for just $1.1 billion. Furthermore, Barnes and Noble has minimal balance sheet debt and low capital expenditure requirements, suggesting it has the potential for being a cash cow for investors.

Unfortunately, Barnes and Noble's current financial statements may understate the rate of decline in this business. While operating profit was $146 million last quarter, which was $6 million higher than it was last year at this time, the company received a $39 million boost to its 2010 operating profit due to a new acquisition (B&N College) which played no role in last year's results. This acquisition removed a bunch of cash and added some debt to the company's balance sheet.

While some of the company's decline may be attributed to cyclical rather than secular effects, Barnes and Noble does face a secular decline on two fronts, which exacerbates and could therefore serve to accelerate its rate of decline. First, customers are changing how they purchase books, shifting more revenue dollars online from bricks and mortar purchases. More recently, however, customers are also changing how they interact with books, using devices such as the Kindle and the iPad. Furthermore, the company has almost $2 billion in operating leases that extend out several years. If much of the recent declines are secular, the company's bricks and mortar operations could yield substantial losses in the near future.

For its part, Barnes and Noble has been jumping into the new methods of distributing books, having released its own e-reader and having made a slew of acquisitions of platforms to support its online presence. Still, only 10% of the company's revenue is from online sources. As such, this foray against the strong competition that's out there adds risk to this investment; rather than receive the cash flow from Barnes and Noble's existing operations, shareholder funds are re-invested in products and services with uncertain outcomes against strong competition.

Barnes and Noble could be successful in transitioning to a method of distribution more suited to the current times. Unfortunately, these investments are fraught with risk. Shareholders seeking to capitalize from a low stock price and a cash generating business may never see a dime, due to the company's desire to invest to attempt to remain a large player in this space.